Chapter 2 Prospective Financial Information

• Jurisdiction: United States

Chapter 2 Prospective Financial Information

This chapter provides an overview of the types of prospective financial information and introduces budgets, forecasts, projections and pro forma financial statements summarizing the intended purposes of such financial information.

Business valuation and related business damages calculations have a long history that predates the modern era. As early as 1908, it was established in U.S. law that the value of a business was, fundamentally, a prediction about the future profits that the business could generate.¹⁵ Nonetheless, courts were not always clear about how such predictions should be made.

Revenue Ruling 59-60

The U.S. Internal Revenue Service (IRS) has made significant contributions to valuation theory and the development of application methods. The IRS has issued many rulings and pronouncements, which do not have the force of law but do present the IRS's positions, and have become guideposts and reference sources for the valuation profession. In 1959, the IRS issued Revenue Ruling 59-60, which is regarded as the single most important piece of valuation literature, and which continues to provide professional guidance related to issues in valuation (see Appendix B).¹⁶ Although it focuses, as one might expect from an IRS document, on issues related to gift and estate taxation, it is widely cited in the valuation profession, since it defines important principles for developing business appraisals of private companies.

Although it is now more than 60 years old, its guiding principles and general philosophy are widely accepted for tax and nontax purposes.¹⁷ Because of its influence on business appraisal and valuation theory, Revenue Ruling 59-60 may also provide professional guidance regarding business damages computations, even though different methods are employed in business valuation and in damages measurement. In 1968, the IRS later issued Revenue Ruling 68-609 that expanded the application of Revenue Ruling 59-60 to the valuation of business interests of any type, stating:

The general approach, methods, and factors, outlined in Revenue Ruling 59-60, as modified, are equally applicable to valuations of corporate stocks for income and other tax purposes as well as for estate and gift tax purposes. They apply also to problems involving the determination of the fair market value of business interests of any type, including partnerships and proprietorships, and of intangible assets for all tax purposes.

Since Revenue Ruling 59-60 outlines the general approaches, methods and factors to consider when valuing shares of capital stock, these methods have been widely adopted by the valuation profession in valuations performed for various litigation and other purposes. An important principle stated in Revenue Ruling 59-60 recognizes that:

[v]aluation of securities is, in essence, a prophesy [sic] as to the future and must be based on facts available at the required date of appraisal. As a generalization, the prices of stocks which are traded in volume in a free and active market by informed persons best reflect the consensus of the investing public as to what the future holds for the corporations and industries represented. (Section 3.03)

While financial professionals are no doubt aware of, and familiar with, the common investment-industry disclaimer "past performance does not guaranty future results," there is no question that past performance provides important data regarding the trends that impact expected or potential future results. Indeed, according to Revenue Ruling 59-60, past results are the best indicators of future results, and thus the best evidence of a business's value:

Potential future income is a major factor in many valuations of closely held stocks, and all information concerning past income which will be helpful in predicting the future should be secured. Prior earnings records usually are the most reliable guide as to the future expectancy, but resort[ing] to arbitrary five- or ten-year averages without regard to current trends or future prospects will not produce a realistic valuation. (Section 4.02(d))

Thus, the IRS concludes that a careful analysis of future prospects, among other factors, is important in order to understand the future earning capacity of a business.

Notwithstanding this important guidance, the IRS does not use the terms "budget," "forecast," "projection," "pro forma" or other similar words within Revenue Ruling 59-60, and the ruling does not define or identify the particular financial documents that should be relied upon when assessing likely future cash flows. Finally, the ruling does not discuss discounted cash flow methods, since it was issued in an era prior to their general use. Nevertheless, this revenue ruling emphasizes in a concise manner the basic principles of the valuation process and contains so many important basic factors that it is still cited today as one of the best foundational treatises issued on valuation.¹⁸

Forward-Looking Financial Documents

The following sections of this chapter offer a broad discussion about the different types of forward-looking financial documents, with an eye toward identifying their differences and clarifying the circumstances in which it is appropriate to apply each type of forward-looking financial document. These more general explanations may need to be reconciled with the language of specific professional standards (see Chapter 3) depending on the circumstances of each situation and the issues under review. The professional standards specify carefully defined assumptions; recognition of the preparer's intent, knowledge and belief; suppositions about the preparer's intended use of the documents; and considerations about the forward-looking time horizon involved. Reliance on or adherence to one or more professional standards may require the various definitions and explanations to be reconciled to identify alternative viewpoints, if necessary. This publication undertakes a more general discussion and interpretation of these documents. We note the various professional standards...